Unknown election outcome is stocks' big fear

A handful of toss-up U.S. Senate races next week could hold the key to whether the stock market glides through the year-end in a typical post-midterm election rally or gets hit with a fresh bout of volatility.

U.S. investors appear less concerned with whether Republicans take control of the Senate, as expected, or Democrats hang on to their majority by a slim margin. They just want to know—come Wednesday morning - the actual outcome.

"If we have a really uncertain situation, where the Senate is divided and candidates are threatening recounts, that's really not good," said Robbert van Batenburg, director of market strategy at Newedge USA in New York.

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Traders work on the floor of the New York Stock Exchange, Oct. 17, 2014.

In two southern matchups—Louisiana and Georgia—polls show the races are too tight to call, raising the potential for run-off elections that could delay for weeks knowing who will control Congress' upper chamber. Louisiana's run-off election is scheduled for Dec. 6. In the market's worst-case scenario, the majority party may not be known until after Jan. 6, when Georgia will hold its run-off election if no Senate candidate wins at least 50 percent of the vote on Nov. 4.

Such an outcome, while considered unlikely, nevertheless rekindles uncomfortable memories for some of the 2000 presidential election, when George W. Bush's victory over Al Gore was not confirmed for more than a month after Election Day. That uncertainty contributed to a spike of almost 11.2 percent in the CBOE Volatility index and a 7.6 percent drop in the S&P 500 from Election Day through the Electoral College vote in late December that certified the outcome.

"While the reaction wouldn't be that dramatic this time, any form of risk could really jolt equities, especially since the Federal Reserve is no longer in the market," van Batenburg said, referring to the U.S. central bank's decision last week to end its massive bond-buying program, a stimulus measure which has been credited with boosting equities.

Clarity could add legs to rebound

U.S. stocks have roared back in the past two weeks after an early October scare fest. The S&P is up more than 8 percent since its recent closing low on Oct. 15 and the VIX has tumbled some 45 percent.

A clear outcome on Tuesday, then, could set the market up for additional upside into the end of the year.

Historically, midterm elections correspond with market strength. Barclays noted that since 1928, the S&P 500 has posted a median return of 7 percent in the 90 days after a midterm, with returns positive 86 percent of the time.

Upside in mid-term election years has historically favored small-caps. Since 1990, the Russell 2000 has risen an average of 4.89 percent between Election Day and the end of the year, compared with a rise of 3.22 percent in the S&P over the same period and a rise of 2.28 percent in the Dow.

Those gains are close to the averages for all years, with the Russell 2000 rising 4.6 percent in the last two months of the year and the S&P up 3.2 percent in the last two months, according to the Stock Trader's Almanac.

Controlling party

Barclays Capital estimates a 64 percent to 90 percent chance that Republicans would win the Senate. With neither party likely to achieve a large enough majority to overturn vetoes or prevent filibusters, however, the actual party in power may not matter much on Wall Street.

A "new composition is unlikely to enact changes in the near term that will alter the direction of the equity market," Barclays wrote. "If the election results are a surprise and Democrats keep control of the Senate, we believe the market reaction would still be muted."

There could be outsized moves in the energy and medical device sectors, two groups with ties to Republican-driven legislation. The GOP is generally opposed to the Affordable Care Act's imposition of a tax on medical device companies to fund the healthcare program, and the party is widely in support of the Keystone Pipeline project, which would connect Canadian oil sands with U.S. refineries.

"If the majority party of the Senate is in doubt, that would cause a lot of volatility for medical device names likeStryker and Medtronic, most likely with a downward bias," said Michael Mullaney, chief investment officer at Fiduciary Trust Co. in Boston.